EMERICH GUTTER. But who is to stand guard over the guards themselves? 1

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1 WHISTLEBLOWERS UNDER DODD-FRANK 753 WHISTLEBLOWERS UNDER THE DODD-FRANK ACT AND THEIR IMPACT ON GATEKEEPERS EMERICH GUTTER But who is to stand guard over the guards themselves? 1 I. Introduction Tucked away amid more than 2,000 pages of legislation, Section 922 of the Dodd-Frank Wall Street Reform and Consumer Protection Act ( Dodd-Frank ) appears innocuous enough. 2 The provisions are less than fifty pages long and do not establish a new regulatory agency or limit investment activity. Instead, section 922 establishes a framework for providing pecuniary rewards to individuals that report information pertaining to violations of U.S. securities laws. 3 Despite their diminutive appearance, the whistleblower provisions threaten to undermine certain professions that serve as gatekeepers by protecting the public from corporate fraud. 4 In doing so, the whistleblower provisions inadvertently impose avoidable costs on corporations while exposing the market to an increased risk of corporate fraud. This note expands on Professor John Coffee s research on gatekeepers by reflecting on gatekeeper failure prior to the 2008 Financial Crisis and examining the impact of whistleblower provisions on these professions. The note begins with background information on how gatekeepers function and why they sometimes fail. Next, a brief description of the Enron bankruptcy and Sarbanes- J.D. Candidate 2012, Boston University School of Law; B.A., 2008, The University of North Carolina at Chapel Hill. I wish to thank Professor Cornelius Hurley for his guidance throughout the development of this note. Additionally, I greatly appreciate the help I received from Valentina Elzon, Jameson Rice and the rest of the staff on the Boston University Review of Banking and Financial Law. Finally, I owe thanks to Jeff Zack, Professor Perry Mehrling and Raj Date for their insight into the financial industry. 1 JUVENAL, THE SIXTEEN SATIRES 45 (Peter Green trans., Penguin Books 3d ed. 1999). 2 Dodd-Frank Wall Street Reform and Consumer Protection Act, Pub. L. No , 922, 124 Stat. 1376, (2010). 3 Id. 4 JOHN C. COFFEE JR., GATEKEEPERS: THE PROFESSIONS AND CORPORATE GOVERNANCE 2 (2006).

2 754 REVIEW OF BANKING & FINANCIAL LAW Vol. 30 Oxley Act illustrates gatekeeper failure and past government responses. The note then examines similarities between the Enron and Lehman Brothers bankruptcies. An overview of Dodd-Frank s whistleblower provisions is followed by statutory analysis asserting that the current program will weaken gatekeepers. Finally, the note proposes regulatory reforms that would maximize the oversight roles of both whistleblowers and gatekeepers. II. The Gatekeeper Theory A. The Gatekeeper Profession A gatekeeper is an outside or independent watchdog or monitor 5 that is able to disrupt misconduct by withholding their cooperation from wrongdoers. 6 A gatekeeper s support of a financial statement or transaction is often essential because it confirms the statement or transaction s legitimacy. 7 The ability to certify business activities depends on the gatekeeper s reputational capital, which refers to the gatekeeper s ability to lend credibility to an activity and thereby assure investors as to the quality of the signal sent by the issuer. 8 The term gatekeeper therefore encompasses many professions, most notably certified public accountants, corporate lawyers, credit rating agencies and securities analysts. Gatekeepers prevent corporate fraud by withdrawing or threatening to withdraw their reputational capital from questionable transactions. 9 For example, a venture capitalist might refuse to invest in a start-up company without an independent accountant first reviewing and approving the company s financial statements. This accountant can provide feedback and help resolve any inaccuracies in the financial statements. Moreover, the accountant effectively 5 Id.; see also Merritt B. Fox, Gatekeeper Failures: Why Important, What to Do, 106 MICH. L. REV. 1089, 1089 (2008) (defining gatekeepers as watchdog[s] for the public ). 6 Reinier H. Kraakman, Gatekeepers: The Anatomy of a Third-Party Enforcement Strategy, 2 J.L. ECON. & ORG. 53, 53 (1986). 7 See John C. Coffee Jr., Understanding Enron: It s About the Gatekeepers, Stupid, 57 BUS. LAW. 1403, 1405 (2002) ( Inherently, gatekeepers are reputational intermediaries who provide verification and certification services to investors. ). 8 COFFEE, supra note 4, at 2. 9 See id.

3 WHISTLEBLOWERS UNDER DODD-FRANK 755 controls the start-up s access to capital because the investment decision s outcome hinges on the accountant s approval. A gatekeeper can therefore close the gate... to the capital markets by withdrawing its reputational capital from a transaction. 10 Conversely, the investment of reputational capital reduces the cost of capital. 11 Informational asymmetries between market participants and issuers are common in financial markets and increase the probability of incorrect valuations. The result is a market for lemons, in which the inability to discern between lowand high-quality goods causes purchasers to demand lower prices, the lemon price for all goods. 12 Issuers therefore sell securities at lower prices due to potential inaccuracies or misrepresentations in the market. 13 Gatekeepers help prevent the formation of a market for lemons by reducing the impact of informational asymmetries. Because gatekeepers are perceived as credible, independent parties, their investment of reputational capital assures the market of an activity s legitimacy. 14 Corporations therefore can sell securities at higher prices because market participants are able to rely on the gatekeeper s credibility despite informational asymmetries. 15 Consequently, the issuer s cost of capital is reduced because the issuer need not discount its securities to compensate for potential inaccuracies. 16 Theoretically, gatekeepers will not risk reputational capital for an individual client s benefit because credibility is difficult to obtain and critical to the gatekeeper s efficacy. Gatekeepers amass 10 Id.; see also Kraakman, supra note 6, at COFFEE, supra note 4, at Id.; see generally George A. Akerlof, The Market for Lemons : Quality Uncertainty and the Market Mechanism, 84 Q.J. ECON. 488, 490 (1970). 13 See COFFEE, supra note 4, at John C. Coffee, Jr., Gatekeeper Failure and Reform: The Challenge of Fashioning Relevant Reforms, 84 B.U. L. REV. 301, 309 (2004) ( Characteristically, the professional gatekeeper essentially assesses or vouches for the corporate client s own statements about itself or a specific transaction. This duplication is desired because the market recognizes that the gatekeeper has a lesser incentive to deceive than does its client and thus regards the gatekeeper s assurance or evaluation as more credible. ) 15 See COFFEE, supra note 4, at 2; see also Akerlof, supra note 12, at 497 (quoting HUGH TINKER, SOUTH ASIA: A SHORT HISTORY 119 (2d ed. 1990)) (describing how investors in underdeveloped countries rely on credible third parties to encourage confidence in [a] venture and stimulate investment ). 16 COFFEE, supra note 4, at 6-7.

4 756 REVIEW OF BANKING & FINANCIAL LAW Vol. 30 reputational capital by repeatedly providing accurate analysis and quality services over a long period of time. 17 Many gatekeepers acquire additional reputational capital by virtue of a license or other certification. 18 For example, a securities analyst gains credibility by becoming a registered representative and continually providing useful recommendations. Similarly, a corporate lawyer obtains reputational capital by passing the bar and structuring successful transactions. Thus, the accumulation of reputational capital requires significant time and effort. 19 Furthermore, gatekeepers cannot certify transactions without credibility, an outcome that causes lost clients and possibly dissolution. 20 Because a gatekeeper s reputational capital is both hard-earned and crucial to its success, the risk of losing reputational capital should deter gatekeepers from acquiescing in fraud. 21 B. Gatekeeper Failure Gatekeeper failure has grown increasingly common, suggesting that reputational capital is not nearly as valuable as once thought. 22 Gatekeeper failure occurs when a gatekeeper lends credibility to a client s fraudulent activity and thereby conveys a false signal to the market. 23 Gatekeeper failure also occurs if a gatekeeper discovers fraud but fails to withdraw its reputational capital See COFFEE, supra note 4, at See Akerlof, supra note 12, at See Coffee, supra note 7, at See Frank Partnoy, Barbarians at the Gatekeepers?: A Proposal for a Modified Strict Liability Regime, 79 WASH. U. L. Q. 491, 497 (2001; COFFEE, supra note 4, at 4 (arguing that Arthur Andersen s failure was the result of negative reputational capital due to its involvement in the Enron collapse). 21 See Coffee, supra note 7, at 1405 ( In theory... reputational capital would not be sacrificed for a single client and a modest fee. ). 22 See COFFEE, supra note 4, at 4 (suggesting that previous assertions that risking reputational capital is irrational are flawed). 23 See COFFEE, supra note 4, at COFFEE, supra note 4, at ( Because [gatekeepers] did not bark, the United States much-vaunted system of corporate governance was suddenly compromised. Red flags had not simply been missed; rather, the sentries upon whom investors relied appeared to have willfully shut their eyes....

5 WHISTLEBLOWERS UNDER DODD-FRANK 757 Professor Coffee proposes a deterrence explanation and a market bubble explanation for gatekeeper failure. 25 According to the deterrence theory, a gatekeeper is more likely to fail if the incentives to acquiesce to its client exceed the potential costs. 26 Incentives might stem from a variety of sources. Highly competitive business environments may cause gatekeepers to yield to clients in order to retain clients. 27 Corporate executives that receive substantial equity-based compensation may coerce gatekeepers into approving questionable activities that create short-term gains in the corporation s stock price. 28 Legislation and judicial opinions have decreased gatekeepers potential liability. 29 For example, the Private Securities Litigation Reform Act of 1995 increased the pleading requirements for class actions, abolished joint and several liability, and limited the availability of treble damages. 30 More recently, the Supreme Court, in Stoneridge Investment Partners, LLC v. Scientific-Atlanta, Inc., held that no implied private right of action exists against aiders and abettors under section 10(b) of the Securities Exchange Act of Although perhaps individually acceptable, the net effect of these trends is a decline in gatekeeper liability. 32 [I]t was as if the lookouts on the Titanic had seen the iceberg and then collectively pretended it was not there. ) (emphasis added). 25 Coffee, supra note 7, at See also COFFEE, supra note 4, at See Coffee, supra note 7, at See Geoffrey Miller, From Club to Market: The Evolving Role of Business Lawyers, 74 FORDHAM L. REV. 1105, 1106 (2005) (arguing that increased competition between law firms pressures lawyers into unethical behavior); Sarah Kellogg, Financial Crisis 2008: Where Were the Lawyers?, WASHINGTON LAWYER, Jan. 2010, at 26 ( Today s competitive business climate and this was true before the economy faltered makes it tricky to sustain long-term relationships between clients and outside counsel, or even in-house counsel for that matter. It also makes it difficult to give advice to clients who may not want to hear it. ). 28 COFFEE, supra note 4, at 62-64; John C. Coffee, Jr., Gatekeeper Failure and Reform: The Challenge of Fashioning Relevant Reforms, 84 B.U. L. REV. 301, (2004). 29 See id. at Id. at Stoneridge Investment Partners, LLC v. Scientific-Atlanta, Inc., 552 U.S. 148, 159 (2008). 32 See Coffee, supra note 28, at 320.

6 758 REVIEW OF BANKING & FINANCIAL LAW Vol. 30 According to the market bubble theory, gatekeepers fail because they become temporarily irrelevant in a bubble market. 33 Bubble economies form when market participants assume that some previous outcome will persist. 34 Investors therefore depend on the continuation of previous events rather than the credibility of gatekeepers, 35 and corporations are less reliant on reputational capital. 36 Thus, the value of reputational capital declines. 37 Additionally, conservative investors are normally overshadowed by aggressive investors during a bubble economy. 38 In such an environment, simply acquiescing to one s client becomes a logical, low-cost strategy. 39 The deterrence theory and market bubble theory can be reconciled. Both explanations assume that gatekeepers are economically rational actors that seek to minimize costs and maximize benefits. 40 Gatekeeper failure, therefore, is more likely in circumstances where the benefits of acquiescing to a client exceed the costs. For example, gatekeeper failure will occur in competitive environments because the benefit of retaining clients exceeds the risk of lost reputational capital. Similarly, gatekeeper failure is likely during a bubble economy because the potential cost of lost 33 Coffee, supra note 7, at See COFFEE, supra note 4, at COFFEE, supra note 4, at 67. See also Coffee, supra note 28, at The recent housing bubble exemplifies this pattern. Consistent growth in housing prices throughout the 1990s and early 2000s produced a notion that a crash was virtually impossible. Participants in the housing market therefore invested heavily, assuming that the pattern would continue. Max Fraser, The House Folds: The Housing Market and Irrational Exuberance, THE NATION, available at (Nov. 25, 2008). 36 See Coffee, supra note 7, at 1412 ( Gatekeepers are necessary only when investors are cautions and skeptical, and in a market bubble, caution and skepticism are largely abandoned. ). 37 See COFFEE, supra note 4, at COFFEE, supra note 4, at 69. See also Coffee, supra note 7, at 1412 ( It is simply dangerous to be sane in an insane world. The securities analyst who prudently predicted reasonably growth and stock appreciation was quickly left in the dust by the investment guru who prophesized a new investment paradigm in which revenues and costs were less important than the number of hits on a Web site. ). 39 Coffee, supra note 7, at See Partnoy, supra note 20, at 497. But see Coffee, supra note 7, at (highlighting additional complications to this simple economic explanation).

7 WHISTLEBLOWERS UNDER DODD-FRANK 759 reputational capital is less than the benefits of approving a questionable transaction. III. Enron: A Case Study in Gatekeeper Failure A. Overview The most widely cited case of gatekeeper failure is the 2001 bankruptcy of Enron Corporation. 41 Originally a natural gas pipeline company, Enron entered the energy trading industry during the 1990s. 42 The company acted as a middleman between energy suppliers and buyers, offering long-term energy contracts at fixed prices. 43 By 2001, Enron had become the seventh largest company in the United States. 44 It was voted Most Innovative on Fortune s list of Most Admired corporations for six years in a row, 45 and, on July 2001, the company reported a forty percent gain in net profits. 46 Six months later, Enron filed what was then the largest corporate bankruptcy in U.S. history, listing assets of more than $49.8 billion 47 Enron, however, was involved in more dangerous innovation, stretching accounting rules to assemble inflated financial statements. For example, the company used mark-to-market accounting when reporting its long-term contracts, which required that it include as revenue the projections of future cash flows from long-term contracts. 48 Enron grossly overstated the value of many of these arrangements. For example, it reported the value of a fifteenyear contract with Indiana-based Eli Lilly at approximately $500 million, basing this projection largely on optimistic predictions of when the state would deregulate electricity. 49 Enron also sought to improve its credit rating by selling fixed assets that produced minimal returns and accounted for 41 See, e.g., COFFEE, supra note 4, at 18; Coffee, supra note 7, at 1403; Fox, supra note 5, at COFFEE, supra note 3, at 19-20; S. REP. NO , at 7 (2002). 43 Paul M. Healy & Krishna G. Palepu, The Fall of Enron, 17 J. ECON. PERSP. 3, 6 (2003). 44 S. REP. NO , at 6 (2002). 45 COFFEE, supra note 4, at Enron Net Rose 40% in Quarter, N.Y. TIMES, July 12, 2001, at C Richard A. Oppel, Jr. & Andrew Ross Sorkin, Enron s Collapse: The Overview, N.Y. TIMES, Dec. 3, 2001, at A1. 48 Healy & Palepu, supra note 43, at 9-10; COFFEE, supra note 4, at Healy & Palepu, supra note 43, at 10.

8 760 REVIEW OF BANKING & FINANCIAL LAW Vol. 30 substantial debt. 50 Where it could not find a buyer, Enron shifted assets to special purpose entities ( SPEs ). SPEs are shell firms to which a parent corporation may transfer both assets and associated liabilities in order to avoid showing them on its own balance sheet. 51 Accounting rules required that third parties make a substantive residual equity capital investment in the SPE, which was interpreted as only three percent. 52 Several of Enron s SPEs fell short of this threshold, however, and the company failed to fully disclose its use of SPEs despite shifting billions of dollars in assets to these entities. 53 Thus Enron appeared asset light by moving fixed assets off its balance sheet while remaining liable for the significant debt used to finance those assets. 54 Doubts about Enron s financial statements and business operations caused the company s stock to decline in late Enron soon reported a net loss of $618 million, 56 causing its stock price to plummet further 57 and casting doubt on its investment-grade rating. 58 Because many of Enron s loans were contingent on the company retaining an investment-grade rating, Enron appeared likely to default on its debt. 59 Enron attempted to arrange a last minute merger with Dynergy, a competitor, but the deal fell through once Dynergy investigated Enron s financial statements. 60 Left without a white knight, Enron filed for bankruptcy on December 2, COFFEE, supra note 4, at 20; S. REP. NO , at COFFEE, supra note 4, at IMPACT OF NONSUBSTANTIVE LESSORS, RESIDUAL VALUE GUARANTEES, AND OTHER PROVISIONS IN LEASING TRANSACTIONS, Emerging Issues Task Force Issue No (Fin. Acct. Standards Bd. 1990); see also COFFEE, supra note 4, at Healy & Palepu, supra note 43, at See COFFEE, supra note 4, at See COFFEE, supra note 4 at Kenneth N. Gilpin, Enron Reports $1 Billion in Charges and a Loss, N.Y. TIMES, Oct. 17, 2001, at C5. 57 Alex Berenson & Richard A. Oppel, Jr., Once-Mighty Enron Strains Under Scrutiny, N.Y. TIMES, Oct. 28, 2001, at A1. 58 COFFEE, supra note 4, at Id. 60 Id. at Id.

9 WHISTLEBLOWERS UNDER DODD-FRANK 761 B. The Gatekeepers Who Failed The circumstances preceding Enron s collapse created an environment conducive to gatekeeper failure. For example, Enron s executives received considerable equity-based compensation. As of Dec. 31, 2000, employee stock option plans accounted for 96 million of Enron s shares, almost thirteen percent of the company s common stock outstanding. 62 Enron s use of equity-based compensation may have caused the company s management to pressure gatekeepers into approving questionable activities to accelerate short-term stock price growth. 63 Additionally, the potential liability faced by gatekeepers had decreased. In 1991, the Supreme Court rejected an argument for a five-year statute of limitations on securities fraud, instead opting for a three year maximum. 64 Congress passed the Private Securities Litigation Reform Act in 1995 and enacted the Securities Litigation Uniform Standards Act of 1998 shortly thereafter, the latter of which prohibited securities fraud class action suits filed in state court. 65 Gains in Enron s stock price also caused market euphoria. In 2000, the stock price swelled 87 percent, despite the bursting of the Dot Com bubble. 66 The growth in Enron s stock may have caused the value of reputational capital to decline. 67 Accountants, attorneys and credit rating agencies played significant roles in Enron s collapse. During the late 1980s and 1990s, many accounting firms shifted their emphasis toward more lucrative consulting work. 68 Enron s accounting firm, Arthur Andersen, epitomized the transition. Of the major U.S. accounting 62 Healy & Palepu, supra note 43, at 13-4; COFFEE, supra note 4, at Healy & Palepu, supra note 43, at 14; COFFEE, supra note 4, at See Lampf, Pleva, Lipkind, Prupis & Petigrow v. Gilbertson, 501 U.S. 350, (1991). 65 Coffee, supra note 14, at 319; see generally Securities Litigation Uniform Standards Act of 1998, Pub. L. No , 101, 112 Stat. 3227, (1998) (Congress enacted SLUSA to prevent private state securities class action lawsuits alleging fraud from being used to frustrate the objectives of the PSLRA). 66 COFFEE, supra note 4, at Id. at See Janet Kidd Stewart & Andrew Countryman, Local Audit Conflicts Add Up, CHI. TRIB., Feb. 24, 2002, at C1 (stating that, on average, Chicago s largest corporations spend three times what they pay for audit services on consulting services by their auditor); COFFEE, supra note 4, at 27.

10 762 REVIEW OF BANKING & FINANCIAL LAW Vol. 30 firms, Arthur Andersen had the largest consulting revenues. 69 In 2000, Enron paid Arthur Andersen $27 million for its consulting services, $2 million more than what it paid for audit services. 70 Enron therefore may have used consulting contracts to coax Arthur Anderson into certifying inaccurate financial statements, further distorting the costs-benefits analysis in favor of gatekeeper failure. 71 Indeed, evidence suggests that the firm was aware of improprieties in Enron s financial statements. On February 5, 2001, Enron s auditors discussed their discomfort with Enron s use of SPEs. 72 Despite their apprehension, the accountants failed to report their concerns to Enron s audit and compliance committee at a subsequent meeting just one week later. 73 The law firm Vinson & Elkins occupied a similar role. Attorneys from the firm were heavily involved in the structuring of 69 Id. 70 Healy & Palepu, supra note 43, at See COFFEE, supra note 4, at ( [I]f the issuer cannot easily threaten the auditor, it can attempt to seduce it with highly lucrative consulting contracts. Bribes work better than threats for a variety of reasons.... ). 72 Kurt Eichenwald & Diana B. Henriques, Enron s Many Strands: The Company Unravels; Enron Buffed Image to a Shine Even as It Rotted From Within, N.Y. TIMES, Feb. 9, 2002, at A1. 73 Berenson & Oppel, Jr., supra note 57. Arthur Andersen s actions extend beyond its failure to notify Enron s audit and compliance committee: When the credit risks at the special purpose entities became clear, requiring Enron to take a write-down, the auditors apparently succumbed to pressure from Enron s management and permitted the company to defer recognizing the charges. Internal controls at Andersen, designed to protect against conflicted incentives of local partners, failed. For example, Andersen s Houston office, which performed the Enron audit, was permitted to overrule critical reviews of Enron s accounting decisions by Andersen s Practice Partner in Chicago. Finally, Andersen attempted to cover up any improprieties in its audit by shredding supporting documents after investigations of Enron by the Securities and Exchange Commission became public. Healy & Palepu, supra note 43, at 15.

11 WHISTLEBLOWERS UNDER DODD-FRANK 763 Enron s SPEs, 74 which were so complex that Enron may have been unable to use the entities without the firm s assistance. 75 Even more concerning, Vinson & Elkins responded to concerns that Enron would implode in a wave of accounting scandals by issuing a report stating that the company need not reevaluate its use of SPEs. 76 Enron announced a $1 billion deduction from its third-quarter earnings the next day. 77 Credit rating agencies also failed to fulfill their oversight role. Significantly, credit rating agencies are paid by the companies that they rate. 78 An issuer therefore can coerce a credit rating agency into preserving a favorable rating by threatening to take its business to a competitor. 79 Additionally, credit rating agencies may be susceptible to concerns that the negative effect of a downgrade could cause financial instability. 80 Regardless of the cause, credit rating agencies failed to downgrade Enron despite obvious signs that the company was unraveling, and Enron s rating remained investment grade until four days before the company declared bankruptcy William S. Lerach, Plundering America: How American Investors Got Taken for Trillions by Corporate Insiders, 8 Stan. J.L. Bus. & Fin. 69, 113 (2002). 75 John Schwartz, Enron s Many Strands: The Lawyers; Troubling Questions Ahead for Enron s Law Firm, N.Y. TIMES, Mar. 12, 2002, at C1. 76 Eichenwald & Henriques, supra note Id. 78 Claire A. Hill, Regulating the Rating Agencies, 82 WASH. U. L.Q. 43, 50 (2004). 79 COFFEE, supra note 4, at 34. but see id. (noting that the potential conflict of interest is not as significant as what is presented by the relationship between auditors and their clients because credit rating agencies have more clients); Hill, supra note 78, at 50-51, (arguing that the value of a credit rating agency s credibility will prevent the agency from failing to fulfill its gatekeeper responsibilities). 80 One factor is pressure on the rating agency because of the devastating consequences of a rating downgrading. In early November, 2001, Moody s was approached by prominent persons to warn it that a downgrading of Enron below investment grade would plunge Enron into bankruptcy and disrupt the nation s capital markets.... The risk that one will trigger a major bankruptcy (and possibly be sued for doing so unjustifiably) has to slow anyone down. COFFEE, supra note 4, at COFFEE, supra note 4, at 34; Richard A. Oppel Jr., Enron s Many Strands: The Hearings; Credit Agencies Say Enron Dishonestly Misled Them, N.Y. TIMES, Mar. 21, 2002, at C6.

12 764 REVIEW OF BANKING & FINANCIAL LAW Vol. 30 C. The Sarbanes-Oxley Act of 2002 Congress responded to the Enron debacle by enacting the Sarbanes-Oxley Act of 2002 ( Sarbanes-Oxley ) on July 30, Although focused on regulating the accounting industry, Sarbanes- Oxley also includes provisions for the protection of whistleblowers and up-the-ladder reporting requirements for corporate attorneys. Sarbanes-Oxley seeks to prevent gatekeeper failure by blocking efforts to place excessive pressure on accounting firms. Section 103 requires that auditors confirm that financial statements are prepared according to generally accepted accounting principles and disclose any material weaknesses in the client s internal controls. 83 Sarbanes-Oxley established the Public Company Accounting Oversight Board to promulgate and enforce rules promoting auditor independence. 84 Meanwhile, section 303 authorizes the SEC to penalize corporate executives for fraudulently influenc[ing], coerc[ing], manipulate[ing], or mislead[ing] any independent or certified accountant engaged in the performance of an audit Sarbanes-Oxley also requires that public companies establish committees composed of independent board members to oversee the company s auditor. 86 The act therefore seeks to maintain a costbenefits balance in favor of gatekeeper oversight by preventing corporate clients from exerting excessive pressure on accounting firms. Sarbanes-Oxley also institutes protections for whistleblowers. Section 806 prohibits public companies from retaliating against employees that communicate information regarding a securities law violation to a federal agency, member of Congress or work supervisor. 87 Such information must pertain to the violation of a rule or regulation of the Securities and Exchange Commission 82 Sarbanes-Oxley Act of 2002, Pub. L. No , 116 Stat. 745 (2002); Elisabeth Bumiller, Bush Signs Bill Aimed at Fraud in Corporations, N.Y. TIMES, July 31, 2002, at A , 116 Stat. at Id.; See JAMES HAMILTON & TED TRAUTMANN, SARBANES-OXLEY MANUAL: A HANDBOOK FOR THE ACT AND SEC RULES 15 (3d ed. 2008) (stating that the PCAOB is a non-governmental and non-profit corporation ) , 116 Stat. at , 116 Stat. at , 116 Stat. at

13 WHISTLEBLOWERS UNDER DODD-FRANK 765 ( SEC ), a federal law protecting shareholders from fraud, or an otherwise specified statute pertaining to fraud. 88 If an employer violates Section 806, the employee must file a claim within ninety days of the retaliatory action. 89 Additionally, Sarbanes-Oxley establishes unique up-theladder reporting requirements that are designed to compel attorneys to report fraud without violating attorney-client confidentiality. 90 Section 307 requires that the SEC issue rules imposing a duty on corporate attorneys to report internally any information pertaining to the violation of securities law. 91 The reporting requirements apply to all attorneys appearing or practicing before the [SEC], 92 a broad phrase encompassing any attorney performing transactional, litigation or advisory services involving the SEC or its rules. 93 The SEC may file a civil suit against attorneys that fail to comply with the reporting requirements. 94 Under the rules promulgated by the SEC, attorneys that become aware of a material violation of securities law must report the violation to the company s chief legal officer, or to the chief legal officer and the chief executive officer. 95 If the attorney reasonably believes that the chief legal officer or chief executive officer did not respond appropriately, he or she may report the violation to the company s audit committee or another committee composed solely of independent board members. 96 If no such committee exists, the attorney may inform the board of directors. 97 Sarbanes-Oxley 88 These statutes are 18 U.S.C. 1341, 1343, 1344 and Id at Id. 90 See 17 C.F.R (b)(1) (2003) ( By communicating [information regarding a violation of securities law] to the issuer's officers or directors, an attorney does not reveal client confidences or secrets or privileged or otherwise protected information related to the attorney's representation of an issuer. ); see generally MODEL RULES OF PROF L CONDUCT R. 1.6 (2007) (articulating the general principle that attorneys should not disclose confidential information pertaining to the representation of a client) , 116 Stat. 745, C.F.R (b)(1) (2003). 93 See HAMILTON & TRAUTMAN, supra note 84, at 141 (defining the broad coverage of appearing or practicing before the Commission ) C.F.R (a) (2003) C.F.R (b)(1) (2003) (b)(3). 97 Id.

14 766 REVIEW OF BANKING & FINANCIAL LAW Vol. 30 therefore provides protection to whistleblowers while requiring that corporate attorneys assist in preventing securities fraud. IV. Lehman Brothers: A New Case Study in Gatekeeper Failure Although identifying a single event as the central catalyst for the 2008 Financial Crisis remains premature, Congress has recognized a number of potential causes, including monetary policy, deregulation and compensation structures. 98 The role of gatekeepers remains largely unaddressed, however, despite evidence suggesting that widespread gatekeeper failure contributed to the Crisis. The bankruptcy of the investment bank Lehman Brothers ( Lehman ) underscores the continuing problem of gatekeeper failure. A. Overview On September 15, 2008, Lehman filed for Chapter 11 bankruptcy, surpassing Enron as the largest corporate bankruptcy in U.S. history. 99 The 158 year-old Wall Street firm had reported $4 billion in profit in 2007, a 22.9 percent increase from its profit in Lehman was a member of the shadow banking system, a $20 trillion network of nonbank financial institutions. 101 Similar to commercial banks, shadow banks are financial intermediaries that conduct maturity, credit, and liquidity transformation without access to central bank liquidity or public sector guarantees. 102 Shadow banks compensate for the absence of government support by 98 See e.g. Fraud Enforcement and Recovery Act of 2009, Pub. L. No , 5(c)(1), 123 Stat. 1617, (2009). 99 See Yalman Onaran & Christopher Scinta, Lehman Files Biggest Bankruptcy Case as Suitors Balk, BLOOMBERG.COM, available at (Sept. 15, 2008). 100 Fortune 500: Lehman Brothers Holdings, FORTUNE, available at ml (last visited Nov. 8, 2010). 101 Tobias Adrian & Hyun Song Shin, The Shadow Banking System: Implications for Financial Regulation 7 (Fed. Reserve Bank of N.Y., Working Paper No. 382); see also Zoltan Pozsar et al., Shadow Banking (Fed. Reserve Bank of N.Y., Working Paper No. 458). 102 Id. at abstract.

15 WHISTLEBLOWERS UNDER DODD-FRANK 767 dispersing the underlying risk on their assets. 103 By grouping loans together into a single security, shadow banks reduce their exposure to risk due to the low probability that the underlying loans will simultaneously default. 104 This securitization process is complex and involves activities such as originating loans, issuing asset-backed securities, underwriting collateralized debt obligations for the security, and then using the security to obtain wholesale funding. 105 Many of these steps involve gatekeepers, including the familiar cast of accountants, lawyers and credit rating agencies. 106 The gatekeeper failure preceding the Lehman bankruptcy involved Lehman s use of repurchase agreements, a form of wholesale funding. In a typical repurchase agreement, an investment bank sends assets, often an asset-backed security or collateralized debt obligation, to another party in exchange for cash. 107 The investment bank then agrees to repay the cash and reclaim the assets at a later date. 108 Although the investment bank only transfers its assets temporarily, accounting rules allow companies to classify repurchase agreements as sales. 109 Lehman grossly misrepresented its financial status by shifting more than $50 billion in toxic assets off its books in undisclosed repurchase agreements. 110 The value of the underlying assets on Lehman s securities plummeted during the Crisis, 111 however, and the counterparties to Lehman s repurchase 103 See Pozsar et al., supra note 101, at 14 ( [T]he shadow banking system transforms risky, long-term loans (subprime mortgages, for example) into seemingly credit-risk free, short-term, money-like instruments, such as the $1, stable net asset value (NAV) shares that are issued by 2(a)-7 money market mutual funds, and are withdrawable on demand, much like a demand deposit at bank. ). 104 Zoltan Pozsar et al., supra note 101, at Id. at Ronald S. Borod, Esq., DLA Piper, LLP, Financial Services Basics: Lord of the Flies (Aug. 26, 2009). 107 Alistair Barr, Do Other Firms Use Lehman s Accounting Drug?, MARKETWATCH.COM, available at (Mar. 12, 2010). 108 Id. 109 Id. 110 Michael J. de la Merced & Andrew Ross Sorkin, Lehman Bros. Hid Borrowing, Examiner Says, N.Y. TIMES, Mar. 12, 2010, at A See Susanne Craig & Mike Spector, Repos Played a Key Role in Lehman s Demise Report Exposes Lack of Information and Confusing Pacts With Lenders, WALL ST. J., Mar. 13, 2010, at B1 ( The basic

16 768 REVIEW OF BANKING & FINANCIAL LAW Vol. 30 agreements demanded additional collateral. 112 Lehman s inability to meet these demands ultimately drove the company to bankruptcy. B. The Gatekeepers Who Failed Similarities between the Enron and Lehman bankruptcies suggest that gatekeeper failure contributed to Lehman s collapse. The circumstances prior to Lehman s failure featured characteristics similar to those that preceded Enron s bankruptcy. For example, Lehman executives earned total cash salaries of approximately $17.5 million between 2000 and By comparison, Lehman s chief executive officer received approximately $461 million from the sale of Lehman shares during that period. 114 Other evidence suggests that competition among gatekeepers may have facilitated gatekeeper failure as well. 115 Furthermore, the legislative and judicial response to Enron s bankruptcy did not increase the potential liability faced by gatekeepers. 116 Sarbanes-Oxley did not reform the Private Securities Litigation Reform Act or the Securities Litigation Uniform Standards Act. 117 Additionally, Sarbanes-Oxley did not establish a private right problem is that the investment banks have become highly dependent on the repo markets for their funding... but they were using a whole bunch of nontraditional securities for those repo agreements... As we got into the second half of 2008, it became very unclear what the value was on a lot of those things ) (quoting Prof. Stephen Lubben of Seton Hall University School of Law). 112 Id. 113 Lucian A. Bebchuck, Alma Cohen, and Holger Spamann, The Wages of Failure: Executive Compensation at Bear Stearns and Lehman (John M. Olin Center for Law, Economics, and Business, Discussion Paper No. 657), available at abstract_id= (2010) (stating that between 2000 and 2008, the top executive teams of Bear Stearns and Lehman received cash salaries of $9 million and $17.5 million respectively). 114 Id. at See Kellogg, supra note 27, at See id. at See Joseph F. Morrissey, Catching the Culprits: Is Sarbanes-Oxley Enough?, 2003 COLUM. BUS. L. REV. 801, (2003) (arguing that Sarbanes-Oxley should have abolished the Private Securities Litigation Reform Act and the Securities Litigation Uniform Standards Act).

17 WHISTLEBLOWERS UNDER DODD-FRANK 769 of action against aiders and abettors for securities fraud, 118 which the Supreme Court confirmed in its decision in Stoneridge Investment Partners, LLC. 119 Meanwhile, gatekeepers experienced a decline in the value of their reputational capital due to the pre-crisis bubble in the housing market. Although details are still emerging, evidence suggests that accountants, attorneys and credit rating agencies failed to fulfill their responsibilities as gatekeepers. Lehman s accounting firm, Ernst & Young, allegedly knew about Lehman s use of repurchase agreements for years 120 and may have ignored warnings about the company s accounting practices. According to reports, Matthew Lee, one of Lehman s Senior Vice Presidents, submitted a letter to Lehman s managers on May 16, 2008, that questioned Lehman s use of repurchase agreements. 121 Lehman directed Ernst & Young to investigate Lee s letter, requesting a full and thorough investigation into each allegation. 122 Subsequent interviews between Ernst & Young and Lee revealed that Lehman had used repurchase agreements to temporarily transfer $50 billion off its balance sheets. 123 Despite the license to conduct a full and thorough investigation, however, Ernst & Young failed to report Lee s allegations to Lehman s Audit Committee. 124 Credit rating agencies failed to downgrade Lehman s rating below investment grade until shortly before the investment bank filed for bankruptcy, despite months of uncertainty surrounding its financial state. 125 Although the credit rating agencies expressed some 118 See id. at (arguing that Sarbanes-Oxley should have instituted aiding and abetting liability for securities fraud). 119 Stoneridge Stoneridge Investment Partners, LLC v. Scientific-Atlanta, Inc., 552 U.S. 148, 159 (2008). 120 Report of Anton R. Valukas, Examiner, In re. Lehman Brothers Holdings Inc., et al., XXX B.R. 1, 948 (Bankr. S.D.N.Y. 2010) (No ). 121 Michael Corkery, Lehman Insider s Letter Warned About Violating Code of Ethics Top Officers Were Told Firm Misled Investors on Assets, WALL ST. J., Mar. 20, 2010, at B Report of Anton R. Valukas, Examiner, supra note 120, at Id. at Id. at David Evans & Caroline Salas, Flawed Credit Ratings Reap Profits as Regulators Fail, BLOOMBERG.COM, Apr. 29, 2009, com/apps/news?sid=au4oix.judz4&pid=newsarchive

18 770 REVIEW OF BANKING & FINANCIAL LAW Vol. 30 discomfort, 126 Standard & Poor s, Moody s and Fitch gave Lehman s bonds an A rating or higher until the day Lehman filed for bankruptcy. 127 Although evidence suggests that gatekeeper failure occurred, the involvement of attorneys in Lehman s bankruptcy is complicated. Prior to Lehman s collapse, the SEC began filing an increasing number of enforcement actions against corporate attorneys. 128 Additionally, Sarbanes-Oxley s up-the-ladder provisions may have altered the perceived duties of corporate attorneys to include gatekeeper responsibilities. 129 Nonetheless, the English law firm Linklaters involvement in Lehman s use of repurchase agreements raises concerns. Lehman needed a true sale opinion letter from an attorney before entering into repurchase agreements. 130 Although it could not procure the letter from a U.S. law firm, 131 Lehman found a willing party in Linklaters, which provided a true sale opinion letter based on English law. 132 Although perhaps technically legal, the letter raises ethical concerns because Linklaters presumably knew that American investors would rely on Lehman s financial statements. Linklaters provision of a true sale opinion letter therefore suggests that attorneys may have failed despite Sarbanes-Oxley s upthe-ladder reporting requirements. 126 See Yalman Onaran, Lehman Said to Be in Discussions About Potential Sale, BLOOMBERG.COM, Sept. 11, 2008, news?pid=newsarchive&sid=a5ucjobnewt0 ( Without a strategic arrangement in the near term, Lehman's credit-ratings may be downgraded, Moody's said yesterday after the New York-based investment bank announced the biggest loss in its 158-year history. ). 127 See id.; see also Evans & Salas, supra note Peter C. Kostant, From Lapdog to Watchdog: Sarbanes-Oxley Section 307 and a New Role for Corporate Attorneys, 52 N.Y.L. SCH. L. REV. 535, 548 ( ) ( In the post-sarbanes-oxley legal environment, the liability climate for corporate lawyers has grown much hotter. Two civil actions have been brought against general counsels alleging breaches of fiduciary duty and fraud, and there have been three criminal proceedings with two convictions and several guilty pleas. Over the past three years [sic] the SEC has also brought thirty enforcement actions, an unprecedented number, against corporate lawyers. ). 129 Id. at Report of Anton R. Valukas, Examiner, supra note 120, at Id. at Id.

19 WHISTLEBLOWERS UNDER DODD-FRANK 771 The circumstances preceding Lehman s collapse indicate that gatekeeper failure is a continuing problem. Additionally, the Lehman and Enron bankruptcies demonstrate that the probability of gatekeeper failure increases in the context of bubble economies and distorted incentive structures. Given the relative frequency of these events, policymakers should enact regulation that strengthens gatekeepers and avoids exacerbating these conditions. Unfortunately, Dodd-Frank falls short of this objective. C. Dodd-Frank and The Whistleblower Provision Congress' response to the Crisis, Dodd-Frank, drastically expands preexisting whistleblower law. Section 922 establishes a Securities and Exchange Commission Investor Protection Fund, in which the SEC deposits monetary sanctions that it collects under securities law. 133 The SEC will pay whistleblowers a reward from this fund for original information that results in a monetary sanction exceeding $1 million. 134 Whistleblowers must disclose such information to the SEC within 180 days of discovering the violation. 135 The amount rewarded will be determined on a case-bycase basis, but must be between ten and thirty percent of the monetary sanction. 136 To encourage whistleblowers to fully disclose all valuable information, the SEC is directed to consider the value of the information and the extent of the whistleblower s assistance when determining a reward. 137 The whistleblower provisions allow any individual, including an employee of the company in question, to act as an informant. 138 A whistleblower is simply defined as any individual who provides... information relating to a violation of the securities laws to the Commission Significantly, this definition could include lawyers, accountants and other gatekeepers. Furthermore, the , 124 Stat. 1376, at See id at Id. at Id. at Id. at Id. at 1842 (defining whistleblower as any individual who provides, or 2 or more individuals acting jointly who provide, information relating to a violation of the securities laws to the SEC). 139 Id.

20 772 REVIEW OF BANKING & FINANCIAL LAW Vol. 30 whistleblower provisions would apply to both private and public corporations. 140 The provisions more unique aspects are the protections afforded to whistleblowers against retaliatory action by employers. 141 Whistleblowers are protected regardless of whether they provide information about violations of Sarbanes-Oxley, the Securities Exchange Act of 1934, or any other law within the SEC s jurisdiction. 142 Additionally, whistleblowers are permitted to make anonymous claims 143 and have a private right of action against employers that take retaliatory action against them. 144 Such claims are subject to a generous statute of limitations of ten years from the date of the employer s retaliation. 145 Compared to Sarbanes-Oxley, Dodd-Frank expands the statute of limitations, the requirements for claiming a reward, and the laws under which an individual may report a violation. 146 Dodd- Frank therefore broadens the pool of potential whistleblowers while providing additional incentivizes to disclose information. Unsurprisingly, the SEC reported hundreds of reports by whistleblowers within months of Dodd-Frank s enactment. 147 This growth in 140 See David Martin et al., Enhanced Protection for Whistleblowers Against Employer Retaliation, COVINGTON & BURLING LLP, July 29, 2010, bdc8/presentation/publicationattachment/e7ed9251-9fa6-46ac-b963-a1ed /Dodd-Frank%20Act%20- %20Enhanced%20Protection%20for%20Whistleblowers%20Against%20E mployer%20retaliation.pdf. 141 See id. (arguing that the whistleblower provisions are a significant expansion of the protections afforded by Sarbanes-Oxley) , 124 Stat. 1376, at 1846; see also Martin et al., supra note 141 (comparing the scope of Sarbanes-Oxley s protection to the protection afforded by Dodd-Frank); Ashby Jones & Joann S. Lublin, Critics Blow Whistle on Law, WALL ST. J., Nov. 1, 2010, at B1 ( The sweeping Dodd- Frank financial reform law passed in July will apply... financial rewards to a much larger universe of wrongdoing, including many types of securities or accounting fraud or bribery allegations, not covered by prior whistleblowing laws. ). 143 See 922, 124 Stat. 1376, at Id. at Id. at 1846; see also Martin et al., supra note See Martin et al., supra note See Jones & Lublin, supra, note 142. The history of qui tam actions is significant in this context. Qui tam actions, which refer to whistleblower suits under the False Claims Act, increased significantly after the Federal